Crowdfunding involves a large group of people contributing money to support a business, individual or campaign. The funds raised are often used as startup capital, or may help a business expand or even avoid going bust. But how do you invest in these funds and how is your money protected? We take a look.
Crowdfunding is relatively new to the UK and the market is small, especially compared to the US. However, there is increasing interest in it as a new way for businesses and individuals to raise funds and for people to invest money.
How it works
Crowdfunding is usually arranged through an online platform, particularly specialist websites and social media.
The business or individual will explain their plans or project in a type of pitch, to try to attract contributions from as many people as possible. Investors can contribute as little as £10 in a business or project, usually with no upper limit.
Most crowdfunding platforms require a specified target to be reached during the fundraising period before the money is passed to the business or individual. This model is known as ‘all or nothing’, with contributions returned to investors if the target is not met.
However, on some platforms the business or individual can decide whether or not to return money to investors if the fundraising target is not reached. This model is known as ‘keep it all’.
Crowdfunding investors will usually receive shares in the business or project they contribute to, though some platforms instead allow for funds raised to be like presales of the goods to be produced or for contributors to receive a reward like a t-shirt or mug.
The benefits
It can be rewarding to be involved in a business or project as it develops, or to support a local initiative, friends or family.
Some crowdfunding platforms promote the potential for higher returns than generally achieved on mainstream investment products. While this may be possible in some cases, a crowdfunding investment is likely to come with greater risk and higher returns are rare.
Nonetheless, crowdfunding could make up part of a diversified portfolio, especially for sophisticated investors.
For businesses, crowdfunding can be a useful way to gain direct access to investors and finance that more traditional investors, venture capitalists or lenders are not prepared to offer.
The risks
Many crowdfunding opportunities are high risk and complex.
There is no guarantee investors will receive a return on funds contributed to a crowdfund. In fact, investors could lose all of their money, as the majority of startup businesses fail.
While you may receive a share of a business or project, dividends are rare and your investment could be diluted if more shares are issued.
It can also take considerable time for a startup business to generate a return, so investors must be prepared to wait until well into the future for a potential return.
This is especially so because most crowdfunds are illiquid, which means it can be difficult or even impossible to claim back money invested or have it converted back into cash. There is also no secondary market to sell your shares or crowdfunding investment.
Unfortunately, where money is changing hands – and especially where it is all done online – there is a risk of fraud, so investors should take care to protect themselves.
How to protect yourself
Make sure you sufficiently understand the business or project, how and when you might get a return, whether you will receive an equity share in the business and the risks involved before investing in a crowdfund.
But do not invest any money you are not prepared to lose – remember that most startup businesses fail.
Find out how your money is protected if the business, project or even the crowdfunding platform collapses – in particular check whether the business has appropriate cash reserves or even insurance supporting it if it fails.
Keep in mind that almost all crowdfunds are not authorised by us and you will not have access to the Financial Ombudsman Service (FOS) or Financial Services Compensation Scheme (FSCS) if things go wrong.
Our view
We believe most crowdfunding should be targeted at sophisticated investors who know how to value a startup business, understand the risks involved and that investors could lose all of their money.
We want it to be clear that investors in a crowdfund have little or no protection if the business or project fails, and that they will probably lose all their investment if it does.
We are also concerned that some firms involved in crowdfunding may be handling client money without our permission or authorisation, and therefore may not have adequate protection in place for investors.
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